MagicDiligence (< 20)

Analog Devices - Thriving in a Digital World

5

Analog Devices (ADI) is one of the largest suppliers of analog semiconductors. Analog chips are used to convert ambient data, such as temperature, sound, pressure, even light, into digitized data that can be processed and acted upon by electronic systems. Analog Devices' main products are used for these conversions, and also for amplifying certain signals, particularly voice, that are then transmitted and received around the globe.

If you have a cell phone, some applications of this company's products are readily apparent. Analog-to-digital (and vice-versa) voice conversion is a key component of digital cellular communications, as the data is sent over the air in digital format and "re-created" into sound by devices supplied by ADI and its competitors. Smart-phones require even more analog components, such as an accelerometer that is used to orient the screen to however the user is holding the device, for sensing ambient light to determine screen brightness, and for proximity sensors to determine when to turn off the touch screen when the user is holding the phone to his/her ear. The rapid growth of both smart-phones and tablets is an opportunity for ADI, as the firm is one of the top suppliers of accelerometers.

Analog Devices' largest end market is industrial, which accounts for over 45% of sales. Other important segments are communications (22%), and consumer (19%). The automotive market drives about 12% of sales. If you think about all of the temperature and pressure monitoring systems required for a vehicle or an automated production system, the importance of analog chips becomes apparent. There are a *lot* of applications out there.

At the same time, analog chips are a much better business than commodity digital components. For one, these chips are usually designed into an end product and can not be simply swapped out for a competitor's offering (unlike digital semiconductors). This greatly limits the price elasticity and inventory problems that digital chipmakers face. Second, barriers to entry in this field are relatively high. Analog circuit design is a practical science that takes many years of experience to develop useful skills in, and the pool of exceptional designers is small. Given the relative consolidation in the field (ADI, Texas Instruments (TXN), ST Micro (STM), and Linear Tech (LLTC) are the only major players), this sets up a limited competition oligarchy, a stark contrast to the hundreds of digital component suppliers, many in low-cost locales like Taiwan or China.

The company itself is firing on all cylinders. In the just reported Q1, revenue rose 18% year-over-year, and record high margins drove a 39% increase in operating income. By moving into higher margin businesses, divesting lower margin ones, and cutting back on manufacturing capacity to increase utilization, Analog Devices has raised operating margin from about 25% in 2006 up to over 35% today. This margin should be sustainable for the foreseeable future. To top it off, ADI has a great balance sheet with over $3.4 billion in cash vs. just over $900 million in total debt.

I believe the future for analog chip demand is very bright. Smart-phones, tablets, even laptop computers now carry half a dozen or more sensors. Analog chips are important in efficient power management, a huge concern for mobile devices (although one ADI has not been able to crack into very well, yet). Automobiles continue to be outfitted with ever more sophisticated systems (think park assist, lane assist, blind spot detect - all of which need sensors to function). There should be a significant amount of demand going forward. 2010 and 2011's big step up over 2008 levels probably shouldn't be used as a barometer, as a lot of pent-up demand from a poor 2009 was realized. But there is no reason ADI cannot grow at 10-15% rates over the next few years.

Given this, and assigning a reasonable, historical multiple on the stock, my price target is $49. That represents a 19% upside from current prices - making this an easy stock to assign a positive rating to. Should ADI decline to back around $40, it will also become an attractive candidate for a Top Buy recommendation.